Cost Drivers

In simple terms, cost driver can be defined as the driver of cost. Just like a driver drives the car, cost driver drives the cost. Cost driver has a great relevance, especially in ABC Costing system. Cost driver analysis is the key to utilizing the concept of cost driver to its full potential. Correct cost driver determination is extremely important for effective management decision making.

What is a Cost Driver?

A Cost Driver is that factor or variable which has a cause and effect relationship with the total cost. The cost driver is the ‘cause’ and the ‘cost incurred’ is the effect of it. If we take an example of fuel cost of running a car, the cost driver (cause) would be ‘No. of Kms Run’ and the total cost (effect) would be ‘total cost of fuel’. The relationship is quite clear. Higher the no. of km run, higher would be the total cost of fuel.

Examples of Cost Drivers

There cannot be an exhaustive list of cost drivers and activities. Some of the common examples of cost drivers are as follows:

Department / Cost Centre / Cost Pool / Activity

Cost Drivers

Purchase department or Purchasing Activity

No. of Purchase Orders created.

Set Up Cost for Machine

No. of Machine Set Ups

Repairs and Maintenance of Machines

No. of Machine Hours Run

Quality Check Department or Cost

No. of Tests conducted

Cost Driver Analysis

Cost driver analysis means analyzing the various possible cost drivers for a particular type of cost or an activity etc. and explaining their cause and effect relationship between the activity and cost driver. It is advisable to use the most correlated cost driver for taking any decisions relating to apportionment of cost, reduction of costs etc. But, it should be noted that correlation is just a way to prove the relationship. Ultimately, cause and effect relationship is a must. Just for example, normally, material cost and labor cost will have a correlation. This does not mean labor cost can be a cost driver for material cost.

Advantage of Cost Drivers

A properly defined cost driver can be of great use for the managers. The precondition is the cause and effect relationship between cost drivers and their respective activity or cost center. If a manager knows with reasonable accuracy that what is driving its costs, he may focus on that reducing the quantity of that cost driver.

Suppose driver for labor cost is defined as material cost. To reduce the high cost of labor, the manager would focus on reducing the material cost where there is no cause and effect relationship. On the other hand, if the labor cost driver is defined to say product design which seems logical. A complex product design may require higher manual labor while a simple design can be operated over a machine.

About The Author

Sanjay Borad is the founder & CEO of training100.ru. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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